Cooper and Haltiwanger (2005)

Review of Economic Studies (2006) 73, 611–633 0034-6527/06/00230611$02.
00

c 2006 The Review of Economic Studies Limited
Downloaded from https://academic.oup.com/restud/article-abstract/73/3/611/1576826 by London School of Economics user on 22 July 2020

On the Nature of Capital
Adjustment Costs
RUSSELL W. COOPER
University of Texas at Austin
and
JOHN C. HALTIWANGER
University of Maryland
First version received January 2002; final version accepted November 2005 (Eds.)
This paper studies the nature of capital adjustment at the plant level. We use an indirect inference
procedure to estimate the structural parameters of a rich specification of capital adjustment costs. In effect,
the parameters are optimally chosen to reproduce a set of moments that capture the non-linear relationship
between investment and profitability found in plant-level data. Our findings indicate that a model, which
mixes both convex and non-convex adjustment costs, fits the data best.
1. MOTIVATION
The goal of this paper is to understand the nature of capital adjustment costs. This topic is central
to the understanding of investment, one of the most important and volatile components of aggre-
gate activity. Moreover, understanding the nature of adjustment costs is vital for the evaluation
of policies, such as tax credits, that attempt to influence investment, and thus aggregate activity.
Despite the obvious importance of investment to macroeconomics, it remains an enigma.
Costs of adjusting the stock of capital reflect a variety of interrelated factors that are difficult
to measure directly or precisely so that the study of capital adjustment costs has been largely
indirect through studying the dynamics of investment itself. Changing the level of capital services
at a business generates disruption costs during installation of any new or replacement capital and
costly learning must be incurred as the structure of production may have been changed. Installing
new equipment or structures often involves delivery lags and time to install and/or build. The
irreversibility of many projects caused by a lack of secondary markets for capital goods acts as
another form of adjustment cost.
Some industry case studies (e.g. Holt, Modigliani, Muth and Simon, 1960; Peck, 1974;
Ito, Bresnahan and Greenstein, 1999) provide a detailed characterization of the nature of the
adjustment costs for specific technologies. A reading of these industry case studies suggest that
there are indeed many different facets of adjustment costs and that, in terms of modelling these
adjustment costs, both convex and non-convex elements are likely to be present.1
1. Holt et al. (1960) found a quadratic specification of adjustment costs to be a good approximation of hiring
and lay-off costs, overtime costs, inventory costs, and machine set-up costs in selected manufacturing industries. These
components of adjustment costs for changing the level of production are relevant here but are by no means the only
relevant costs. In terms of changes in the level of capital services, Peck (1974) studies investment in turbo-generator sets
for a panel of 15 electric utility firms and found that “The investments in turbogenerator sets undertaken by any firm took
place at discrete and often widely dispersed points of time”. In their study of investment in large scale computer systems,
Ito et al. (1999) also find evidence of lumpy investment. Their analysis of the costs of adjusting the stock of computer
611
612 REVIEW OF ECONOMIC STUDIES
Despite this perspective from the industry case studies, the workhorse model of the invest-
ment literature has been a standard neoclassical model with convex costs (often approximated to
be quadratic) of adjustment. This model has not performed that well even at the aggregate level

(see Caballero, 1999), but the recent development of longitudinal establishment databases has
raised even more questions about the standard convex cost model.
An alternative approach, highlighted in the work of Abel and Eberly (1994, 1996), Doms
and Dunne (1994), Caballero, Engel and Haltiwanger (1995), and Cooper, Haltiwanger and
Power (1999), argues that non-convexities and irreversibilities play a central role in the invest-
ment process. The primary basis for this view, reviewed in detail in the following, is plant-level
evidence of a non-linear relationship between investment and measures of fundamentals, includ-
ing investment bursts (spikes) as well as periods of inaction.
One limitation of this recent empirical literature is that it has focused primarily on reduced-
form implications of non-convex vs. convex models. The results that emerge reject the reduced-
form implications of a pure convex model and are consistent with the presence of non-convexities.
The reduced-form nature of the results have left us with several important, unresolved questions:
what is the nature of the capital adjustment process at the micro-level? Does the micro-evidence
support the presence of both convex and non-convex components of adjustment costs as might
be expected based upon the limited number of industry case studies? More specifically, what are
the structural estimates of the convex and non-convex components of adjustment costs that are
consistent with the micro-evidence? Finally, what are the aggregate and policy implications of
the estimated investment model?
To address these questions, this paper considers a rich model of capital adjustment, which
nests alternative specifications. To do so, we specify a dynamic optimization problem at the plant
level, which incorporates both convex and non-convex costs of adjustment as well as irreversible
investment. The model’s implications are matched with plant-level observations from the Longi-
tudinal Research Database (LRD) as part of a minimum distance estimation routine. We recover
structural estimates of adjustment costs.
There are a couple of key features of the data, which guide the estimation: the frequency
of large bursts of investment, the positive correlation between investment, and the marginal prof-
itability of capital and the relatively low serial correlation of investment. All of these moments
are computed at the plant level. These moments are chosen partly due to their prominence in
the literature and partly due to their informativeness about the underlying structural parameters,
which we estimate.
Our results can be summarized by referring to extreme models.2 In the absence of adjust-
ment costs, investment is excessively responsive to shocks and is negatively serially correlated.
From this perspective, the role of adjustment costs is to temper the response of investment to
fundamentals and to create the slightly positive serial correlation of investment observed at the
plant level. The convex cost of adjustment model is not sufficiently sensitive to shocks and cre-
ates excessively significant positive serial correlation of investment rates. In particular, a model
with convex costs alone cannot produce the bursts of investment and inaction observed in the
data. Thus, richer models of adjustment are needed. Both the non-convex and the irreversibility
models are able to produce relationships between investment and fundamentals, which are much
closer to the data. Both of these models imply inactivity and investment bursts. Interestingly,
irreversibility creates an asymmetry as well since the loss from capital sales is more relevant
capital include items, which they term “. . . intangible organization capital such as production knowledge and tacit work
routines”. Hamermesh and Pfann (1996) also provide a detailed review of convex adjustment cost models and numerous
references to the motivation and results of that lengthy literature.
2. These comments pertain to the models studied in Section 3 and summarized in Tables 2 and 3. As explained,
these statements reflect not only the adjustment costs but also the driving processes.

COOPER & HALTIWANGER ON THE NATURE OF CAPITAL ADJUSTMENT 613
when profitability shocks are below their mean. From our estimation of a structural model of
adjustment, a combination of non-convex adjustment costs and irreversibility enables us to fit
prominent features of observed investment behaviour at the plant level. In particular, a model of

adjustment in which the non-convex costs entail disruption of the production process fits the data
best.
In terms of macroeconomic implications, the natural question is whether these non-
convexities “matter” for aggregate investment. Our findings indicate that at the plant level, the
non-convexities identified in our estimation are important: a model with only convex adjustment
does poorly at the plant level. However, a model with only convex adjustment costs fits the ag-
gregate data created by our estimated model reasonably well though (as reported independently
by Cooper et al., 1999, hereafter CHP) the convex models tend not to track investment well at
turning points. Thus, we find that the non-convexities are less important at the aggregate relative
to the plant level. We relate this finding to results reported by Caballero and Engel (1999) and
Thomas (2002) in Section 5.
2. FACTS
In this section we discuss our data-set. We then present some moments from the data, which will
guide the remainder of the analysis.
2.1. Data-set
Our data are a balanced panel from the LRD consisting of approximately 7000 large, manufac-
turing plants that were continually in operation between 1972 and 1988.3 This particular sample
period and set of plants is drawn from the data-set used by Caballero et al. (1995), hereafter
CEH. The unique feature of this data relative to other studies that have used the LRD to measure
investment is that information on both gross expenditures and gross retirements (including sales
of capital) are available for these plants for these years (Census stopped collecting data on retire-
ments in the late 1980’s in its Annual Survey of Manufactures, which is why our sample ends
in 1988). Incorporating retirements (and in turn sales of capital) is especially important in this
exploration of adjustment costs and frictions in adjusting capital at the micro-level. Investigating
the role of transactions costs and irreversibilities is quite difficult with the use of expenditures
data alone.
The use of the retirements data requires a somewhat modified definition of investment. The
definition of investment and capital accumulation follows that of CEH and satisfies
It = EXPt − RETt (1)
K t+1 = (1 − δt )K t + It , (2)
where It is our investment measure, EXPt is real gross expenditures on capital equipment, RETt
is real gross retirements of capital equipment, K t is our measure of the real capital stock (gen-
erated via a perpetual inventory method at the plant level), and δt is the in-use depreciation rate.
This measurement specification differs from the usual one that uses only gross expenditures data
and the depreciation rate captures both in-use and retirements. Following the methodology used
in CEH, we use the data on expenditures and retirements along with investment deflators and
3. While the balanced panel enables us to avoid modelling the entry/exit process there is likely a selection bias
induced. Our use of the balanced panel is based on the difficult measurement issues for measuring real capital stocks and
in turn real capital expenditures and real capital retirements. The details of this measurement are described in Caballero
et al. (1995).

Bureau of Economic Analysis (BEA) depreciation rates to construct real measures of these series
and also an estimate of the in-use depreciation rate.4 In what follows, we focus on the investment
rate, It /K t , which can be either positive or negative.

2.2. Investment moments
The histogram of investment rates that emerges from this measurement exercise is reported in
Figure 1. It is transparent that the investment rate distribution is non-normal having a considerable
mass around 0, fat tails, and is highly skewed to the right (standard tests for non-normality yield
strong evidence of skewness and kurtosis). Some of the main features of the distribution (and
its underlying components in terms of gross expenditures and retirements) are summarized in
Table 1.
First, note that about 8% of the (plant, year) observations entail an investment rate near 0
(investment rate less than 1% in absolute value). Of this inaction, about 6% of the observations
indicate gross expenditures less than 1% of the plant capital stock and the retirement rate is less
than 1% in 42·3% of our observations. This inaction is one of the driving observations for our
analysis.5
These observations of inaction are complemented by periods of rather intensive adjustment
of the capital stock. In the analysis that follows we term episodes of investment rates in excess of
20% spikes. Investment rates exceed 20% in about 18% of our sample observations. On average
these large bursts of investment account for about 50% of total investment activity. Decomposing
the investment rate in terms of gross expenditures and retirements, there are gross expenditure
spikes in approximately 23% of the observations, while negative investment spikes occur in about
1·8% of the observations.
These properties of the investment distribution illustrate a key feature of the micro-data:
investment rates are highly asymmetric. It is important to emphasize that our measurement of
negative investment is through a direct measurement of retirements reflecting purposeful selling
or destruction of capital. We find a negative investment rate in roughly 10% of our observations,
zero investment in almost 10%, and positive investment rates in the remaining 80% of our ob-
servations. This striking asymmetry between positive and negative investment is an important
feature of the data that our analysis seeks to match.
Table 1 also reports the serial correlation of investment rates computed as the simple cor-
relation of the plant-level investment rate with the lagged investment rate. Interestingly, this is
surprisingly low at the plant level relative to the common perception of highly serially correlated
shocks to demand and productivity. It is important to remember though that the correlation of the
investment rate also reflects adjustment costs.
The second correlation is between investment rates and a measure of profitability at the
plant level. This correlation is positive at the plant level, indicating that investment rates are high
in periods of high profitability. In contrast to the other moments, this last correlation requires a
model as a device to measure profitability shocks. Section 4.1.1 discusses this measurement.
4. A relevant measurement point is that the retirement data are based upon sales/retirements of capital, which
yield a change in the book value of capital. Using a first in, first out (FIFO) structure and the history of investment and
retirements, CEH develop a method to convert this to a real measure of retirements. The methodology yields a measure
of the real changes in the plant-level capital stock induced by retirements. In what follows, it is important to note that
this procedure does not already capture the difference between buying and selling prices of capital that may influence the
adjustment process. We recover that difference in our estimation.
5. Observations of inaction and investment bursts are found in data from other countries as well. For example,
Nilsen and Schiantarelli (1998) study investment in Norwegian manufacturing plants for the period 1978–1991. For
production units, they report that 21% of the units have zero investment expenditures over a given year. Further, they
find that investment rates exceeding 20% arise in about 10% of their observations and account for about 38% of total
equipment investment. Related evidence on the lumpy nature of investment for Colombia is provided by Huggett and
Ospina (2001).


F IGURE 1
Investment rate distribution
TABLE 1
Summary statistics
Variable LRD
Average investment rate 12·2% (0·10)
Inaction rate: investment 8·1% (0·08)
Fraction of observations with negative investment 10·4% (0·09)
Spike rate: positive investment 18·6% (0·12)
Spike rate: negative investment 1·8% (0·04)
Serial correlation of investment rates 0·058 (0·003)
Correlation of profit shocks and investment 0·143 (0·003)
LRD, Longitudinal Research Database.
The S.E. of these moments are provided in parentheses in Table 1.6 Given the size of the
data-set (these moments are all based on more than 100,000 plant–year observations), these mo-
ments are all very precisely estimated. Such precision should not be interpreted as reflecting little
dispersion at the plant level. At the micro-level, there is substantial dispersion. For example, the
average investment rate is 12·2, but the S.D. of micro-investment is 33·7. Nevertheless, with a
very large sample we estimate the mean and other moments of micro-investment very precisely.
In what follows, we exploit the micro-heterogeneity explicitly as we use the estimated dispersion
of profit shocks from the micro-data.
6. The S.E. reported in Table 1 for the variables reported as percentages are in the same units. Later in the paper
we use these same variables as fractions with appropriate adjustment of units of S.E.

We estimate adjustment cost parameters by using a simulated method of moments approach.

This approach requires selecting moments to match. Theoretical and practical considerations
suggest that the moments should be relevant in identifying the adjustment cost parameters and

are also precisely estimated. We regard the four moments in Table 1 as capturing key features of
the behaviour of investment at the micro-level.
The first moment is the serial correlation in investment. It is well established in the adjust-
ment cost literature (see, for example, Caballero and Engel, 2003; and CHP) that the serial cor-
relation of investment is sensitive to the structure of adjustment costs. The second moment is the
correlation between investment and profit shocks as it reflects the covariance structure between
investment and the shocks to profits. This moment and the others we match are quite sensitive
to the adjustment cost parameters and in this sense satisfy the relevance criterion. The other two
moments capture key features of Figure 1 that have been emphasized in the literature—namely,
the investment distribution at the micro-level is very asymmetric and has a fat right tail. To cap-
ture these features, we use the positive and negative spike rates in Table 1. Each of these four
moments captures key features of investment behaviour at the micro-level, but the exact choice
of moments is an open question. In what follows, we use these four moments in our empirical
analysis and then present some analysis of robustness of our findings to the choice of alternative
moments.
Before proceeding, it is worth noting that one moment we choose not to match directly is
the fraction of observations with inaction. While Table 1 shows some range of inaction, the more
robust finding in Figure 1 and Table 1 is that the distribution of investment is skewed and kurtotic
with a fat right tail. Identifying inaction precisely at the micro-level is difficult because in practice
there is substantial heterogeneity in capital assets with associated heterogeneity in adjustment
costs. For example, buying a specific tool gets lumped into capital equipment expenditures in
the same way as retooling the entire production line. Explicitly analysing the role of capital
heterogeneity is beyond the scope of this paper, but we discuss this as an area of future research
in the concluding remarks.
3. MODELS AND QUANTITATIVE IMPLICATIONS

Our most general specification of the dynamic optimization problem at the plant level is assumed
to have both components of convex and non-convex adjustment costs as well as irreversibility.
Formally, we consider variations of the following stationary dynamic programming problem:
V (A, K ) = max ( A, K ) − C(I, A, K ) − p(I )I + β E A |A V (A , K ) ∀(A, K ), (3)

I
where ( A, K ) represents the (reduced-form) profits attained by a plant with capital K , a prof-
itability shock given by A, I is the level of investment, and K = K (1 − δ) + I. Here unprimed
variables are current values and primed variables refer to future values. In this problem, the man-
ager chooses the level of investment, denoted I , which becomes productive with a one period lag.
The costs of adjustment are given by C(I, A, K ). This function is general enough to have com-
ponents of both convex and non-convex costs of adjustment. Irreversibility is encompassed in the
specification if the price of investment, p(I ), depends on whether there are capital purchases or
sales.
Current profits, for given capital, are given by ( A, K ), where the variable inputs (L) have
been optimally chosen, a shock to profitability is indicated by A, and K is the current stock of
capital. That is,
( A, K ) = max R( Â, K , L) − Lw(L),
L

TABLE 2
Parameterization of illustrative models
γ λ

Model F ps pb
No AC 0 0 1 1 1
CON 2 0 1 1 1
NC-F 0 0·01 1 1 1
NC-λ 0 0 0·95 1 1
TRAN 0 0 1 0·75 1
TABLE 3
Moments from illustrative models
Moment LRD No AC CON NC-F NC-λ TRAN

Fraction of inaction 0·081 0·0 0·038 0·616 0·588 0·69
Fraction with positive investment bursts 0·18 0·298 0·075 0·212 0·213 0·120
Fraction with negative investment bursts 0·018 0·203 0·0 0·172 0·198 0·024
Corr (i it ,i it−1 ) 0·058 −0·053 0·732 −0·057 −0·06 0·110
Corr (i it , ait ) 0·143 0·202 0·692 0·184 0·196 0·346
where R( Â, K , L) denotes revenues given capital (K ), variable inputs (L), and a shock to rev-
enues, denoted Â. Here, Lw(L) is total cost of variable inputs. Clearly, this formulation assumes
there are no costs of adjusting labour. Once we specify a revenue function, we can use this
optimization problem to determine L and to derive the profit function ( A, K ), where A reflects
both the shocks to the revenue function and variations in costs of L. Throughout the analysis, the
plant-level profit function is specified as
( A, K ) = AK θ . (4)
This section of the paper provides an overview of the competing models of adjustment. The
parameterizations are summarized in Table 2.7 For each, we describe the associated dynamic pro-
gramming problem and display some of the quantitative predictions of the models in Table 3. At
this stage these quantitative properties are meant to facilitate an understanding of the competing
models. Accordingly, the parameter values are set to “reasonable” levels from the literature. The
next section of the paper discusses estimation of underlying parameters.
3.1. Common elements of the specification

For the following simulations, the aggregate and idiosyncratic shocks are represented by first-
order, Markov processes. Following Tauchen (1986), the set of aggregate and idiosyncratic prof-
itability states as well as the transition matrices are chosen to reproduce the variance and serial
correlation of the profitability shocks inferred from our analysis of plant-level profitability. For
the remaining parameters, we set the annual discount factor (β) at 0·95 and the annual rate of
depreciation at (δ) 6·9%. This depreciation rate is consistent with the one used to create the
capital stock series at the plant level, less a retirement rate of 3·2%.
7. In the estimation, determining the value of θ and the parameterization of the stochastic process for A is, of
course, critical. The simulations that follow use the estimated values, which are discussed in Section 4.1.1.

3.2. Convex costs of adjustment

The traditional investment model assumes that costs of adjustment are convex. Here, we adopt a
quadratic cost specification and consider the following specification of the adjustment function,

γ
C(I, A, K ) = (I /K )2 K ,
2
where γ is a parameter. The first-order condition for the plant-level optimization problem relates
the investment rate to the derivative of the value function with respect to capital and the cost of
capital, p. That is, the solution to (3) implies
i = (1/γ )[β E Vk (A , K ) − p], (5)
where i is the investment rate, (I /K ), and E Vk is the expectation of the derivative of the value
function in the subsequent period. In practice, this derivative is not observable.
As suggested by (5), the investment rate reflects the difference between the expected margi-
nal value of capital, E Vk (A , K ) and the cost of capital p. From this condition and the one-period
time to build assumption, investment responds to predictable variations in profitability.
If profits are proportional to the capital stock, θ = 1, the model reduces to the familiar
“Q theory” of investment in which the value function is proportional to the stock of capital.
As in Hayashi (1982), the derivative of the value function can be inferred from the average value
of a firm, Vk (A, K ) = V (A, K )/K .
In the special case of no adjustment costs, C(I, A, K ) ≡ 0, from (3), the optimal capital
stock for the plant satisfies
β E Vk (A , K ) = p.
In the absence of adjustment costs, investment will be very responsive to shocks: there will,
indeed, be bursts of positive and negative investment.
3.3. Non-convex costs of adjustment

Building upon the analysis of Rothschild (1971), Cooper and Haltiwanger (1993), Abel and
Eberly (1999), Caballero and Engel (1999), and Cooper et al. (1999), during periods of invest-
ment plants incur a fixed adjustment cost. Generally, these non-convex costs of adjustment are
intended to capture indivisibilities in capital, increasing returns to the installation of new cap-
ital, and increasing returns to retraining and restructuring of production activity. These fixed
adjustment costs represent the need for plant restructuring, worker retraining, and organizational
restructuring during periods of intensive investment.
For this formulation of adjustment costs, the dynamic programming problem is specified as:
V (A, K ) = max{V i (A, K ), V a (A, K )} ∀(A, K ),
where the superscripts refer to active investment “a” and inactivity “i”. These options, in turn,
are defined by
V i (A, K ) = ( A, K ) + β E A |A V (A , K (1 − δ))
and
V a (A, K ) = max ( A, K )λ − F K − p I + β E A |A V (A , K ).
I
In this second optimization problem, as in CHP, there are two types of fixed costs of adjustment.
Both, importantly, are independent of the level of investment.

The first adjustment cost, λ < 1, represents an opportunity cost of investment. If there is
any capital adjustment, then plant productivity falls by a factor of (1 − λ) during the adjustment
period. Studies by Power (1998) and Sakellaris (2001) provide evidence that plant productivity

is lower during periods of large investment.8
All else the same, this form of adjustment cost implies that investment bursts are less costly
during periods of low profitability as adjustment costs are low. But this need not imply a nega-
tive correlation between investment and profitability, since there is a gain to investment in high
productivity states if there is sufficient serial correlation in the profitability shocks.
The second fixed cost of adjustment, denoted F, is independent of the level of activity at the
plant. It is proportional to the level of capital at the plant to eliminate any size effects. Similar
results are obtained if the cost is proportional to the plant-specific average capital stock. Thus
this cost will naturally produce a positive correlation between investment rates and profitability.
The intuition for optimal investment policy in this setting comes from CHP. In the absence
of profitability shocks, the plant would follow an optimal stopping policy: replace capital if and
only if it has depreciated to a critical level. Adding the shocks creates a state-dependent optimal
replacement policy but the essential characteristics of the replacement cycle remain: there is
frequent investment inactivity punctuated by large bursts of capital purchases/sales. Thus, the
model is able to produce both the inaction and bursts highlighted in Table 1. Relative to the
partial adjustment of the convex model, the model with non-convex adjustment costs provides an
incentive for the firm to “overshoot its target” and then to allow physical depreciation to reduce
the capital stock over time.
3.4. Transactions costs

Finally, as emphasized by Abel and Eberly (1994, 1996), it is reasonable to consider the possibil-
ity that there is a gap between the buying and selling price of capital, reflecting, inter alia, capital
specificity and a lemons problem. This is incorporated in the model by assuming p(I ) = pb if
I > 0, and p(I ) = ps if I < 0 where pb ≥ ps . In this case, the gap between the price of new and
old capital will create a region of inaction.
The value function for this specification is given by
V (A, K ) = max{V b (A, K ), V s (A, K ), V i (A, K )} ∀(A, K ),
where the superscripts refer to the act of buying capital “b”, selling capital “s”, and inaction “i”.
These options, in turn, are defined by
V b (A, K ) = max ( A, K ) − pb I + β E A |A V (A , K (1 − δ) + I ),

I
V s (A, K ) = max ( A, K ) + ps R + β E A |A V (A , K (1 − δ) − R),

R
and
V i (A, K ) = ( A, K ) + β E A |A V (A , K (1 − δ)).
Here, we distinguish between the purchase of new capital (I ) and retirements of existing capital
(R). As there are no vintage effects in the model, a plant would never simultaneously purchase
and retire capital.9
8. Incorporating this into our model implies some potential misspecification of profitability shocks since it is
necessary to distinguish λ and low realizations of profitability shocks. We return to this point in detail later.
9. Though, as suggested by a referee, time aggregation may in fact generate observations of both sales and pur-
chases over a period of time.

The presence of irreversibility will have a couple of implications for investment behaviour.
First, there is a sense of caution: in periods of high profitability, the firm will not build its capital
stock as quickly since there is a cost of selling capital. Second, the firm will respond to an

adverse shock by holding on to capital instead of selling it in order to avoid the loss associated
with ps < pb .
3.5. Evaluation of illustrative models

As indicated by Table 2, we explore the quantitative implications of five models. While these
parameterizations are not directly estimated from the data, they provide some interesting bench-
mark cases that highlight the key issues arising between models with convex and non-convex
costs of adjustment.
The first, denoted “No AC” is the extreme model in which there are no adjustment costs.
The second row, denoted “CON”, corresponds to a specification in which there are only convex
costs of adjustment. The case labelled “NC-F” assumes that there are only non-convex costs
of adjustment with F > 0, λ = 0. The case labelled “NC-λ” is a second non-convex cost of
adjustment case with F = 0, λ = 0·95. Finally, the case labelled “TRAN” imposes a gap of 25%
between the buying and selling price of capital.
Our quantitative findings for the specifications in Table 2 along with data from the LRD are
summarized in Table 3. As noted earlier, there is evidence of lumpiness and inaction in the LRD.
In addition, there is low autocorrelation in plant-level investment, which is noteworthy, given that
both aggregate and idiosyncratic shocks to profitability exhibit substantial serial correlation.
Comparing the columns of Table 3 pertaining to the illustrative models with the column la-
belled LRD, none of the models alone fits these key moments from the LRD. The extreme case of
no adjustment costs (labelled No AC) is given in the second column. This model produces no in-
action but is capable of producing bursts in response to variations in the idiosyncratic profitability
shocks. It also generates a large fraction of observations with negative investment bursts. Overall,
the model without adjustment costs is very responsive to shocks. Evidently, the empirical role of
adjustment costs is to temper the response of investment to fundamentals.
The quadratic adjustment cost model (denoted CON) adds convex adjustment costs to the
No AC model. This specification mutes the response of investment to profitability shocks as the
fraction of positive and negative spikes is significantly reduced.10 Further, the convex cost of
adjustment model, through the smoothing of investment, creates serial correlation in investment
relative to the shock process. Consequently, the correlation of investment and profitability is
higher than in the No AC case.
Both treatment of non-convex costs of adjustment (NC-F and NC-λ) and/or the model with
irreversibility (TRAN) are able to create investment inactivity at the plant level. However, the
non-convex models create negative serial correlation in investment data and a lower correlation
between investment rates and profitability. The negative serial correlation of the non-convex ad-
justment cost models is analogous to the upward sloping hazards characterized by CHP. All of
the models are able to produce both positive and negative spikes but, naturally, the asymmetry in
spike rates is most prominent in the irreversibility specification.
4. ESTIMATION
None of these extreme models is rich enough to match key properties of the data. The model we
estimate includes convex and non-convex adjustment processes as well as irreversible investment.
10. There is a small amount of inaction, which reflects the discrete state space approximation of our quantitative
approach.

This combining of adjustment cost specifications may be appropriate for a particular type of
capital (with say installation costs and some degree of irreversibility) and/or may also reflect
differences in adjustment cost processes for different types of capital. As the data is not rich

enough to study a model with heterogeneous capital, our approach is to consider a hybrid model
with all forms of adjustment costs and, in turn, to estimate the key parameters of this specification
by matching the implications of the structural model with relevant features of the data.
The adjustment cost parameters are estimated using the following routine. For arbitrary
values of the vector of parameters, = (F, γ , λ, ps ), the dynamic programming problem is
solved and policy functions are generated. Using these policy functions, the decision rule is
simulated, given arbitrary initial conditions, to create a simulated version of the LRD.11 We then
calculate a set of moments from the simulated data, which we denote as s (). This vector of
moments depends on the vector of structural parameters, , in a non-linear way.
The estimate ˆ minimizes the weighted distance between the actual and simulated mo-
ments. Formally, we solve
£() = min[ d − s ()] W [ d − s ()], (6)

where W is a weighting matrix. This simulated method of moments procedure will generate a
consistent estimate of θ. We use the optimal weighting matrix given by an estimate of the inverse
of the variance–covariance matrix of the moments.12
Of course, the s () function is not analytically tractable. Thus, the minimization is
performed using numerical techniques. Given the potential for discontinuities in the model and
the discretization of the state space, we used a simulated annealing algorithm to perform the
optimization.
For the estimation, we consider two specifications of non-convex adjustment costs. In one,
which we term the fixed cost case, the costs are represented by a lump-sum cost of adjustment
F > 0 without any opportunity costs of adjustment λ = 1. In the second, which we term the
opportunity cost case, F = 0 and λ < 1. These are taken as leading specifications in the litera-
ture, and thus our estimation provides insights into which is more capable of capturing relevant
features of the data.13
In addition to the adjustment cost parameters, the dynamic optimization problem is also
parameterized by the curvature of the profitability function and the process governing the shocks
to profitability. The two specifications of adjustment costs, particularly the presence of disruption
effects, require different approaches to uncovering the underlying shocks to profitability and
characterizing the profitability function.
4.1. Estimation with fixed costs: F > 0 and λ = 1

Assume that the dynamic programming problem for a plant is given by
V (A, K ) = max{V b (A, K ), V s (A, K ), V i (A, K )} ∀(A, K ), (7)
where, as above, the superscripts refer to the act of buying capital “b”, selling capital “s”, and
inaction “i”. These options, in turn, are defined by
11. The simulation is for 500 periods. The initial 15 periods are not used in calculating moments so that the results
are independent of the assumed initial conditions. The moments are not sensitive to adding more periods to the simulation
or to dropping more of the initial periods.
12. See Smith (1993) for details of methodology and measurement of the weighting matrix. In our case, given the
large micro data-set we use we estimate the moments that we are attempting to match very precisely. As such, most of
the moments we are attempting to match receive a very large weight in (6).
13. Caballero and Engel (1999) consider λ < 1 and F = 0, while Thomas (2002) assumes λ = 1, and F is random.

γ
V b (A, K ) = max ( A, K ) − F K − I − (I /K )2 K + β E A |A V (A , K (1 − δ) + I ),
I 2
γ
V s (A, K ) = max ( A, K ) − F K + ps R − (R/K )2 K + β E A |A V (A , K (1 − δ) − R),

R 2
and
V i (A, K ) = ( A, K ) + β E A |A V (A , K (1 − δ)).
We have specified some parameters of the model (β = 0·95, δ = 0·069, pb = 1) for the functional
forms discussed above. Further, we retain our specification of the profit function, ( A, K ) =
AK θ . For the structural estimation, we focus on three parameters, ≡ (F, γ , ps ), which char-
acterize the magnitude of the non-convex and the convex components of the adjustment process
and the size of the irreversibility of investment. As explained next, we estimate the curvature of
the profit function and the A process independently of the dynamic programming problem.
4.1.1. Estimates of θ and measuring profitability shocks. Using the assumption of λ =

1, profits at plant i in period t are given by
( Ait , K it ) = Ait K itθ , (8)
regardless of the level of investment activity. Suppose that ait ≡ ln(Ait ) has the following
structure
ait = bt + εit , (9)
where bt is a common shock and εit is a plant-specific shock. Assume εit = ρε εi,t−1 + ηit . Taking
logs of (8) and quasi-differencing yields
πit = ρε πit−1 + θkit − ρε θ kit−1 + bt − ρε bt−1 + ηit . (10)
We estimate this equation via generalized method of moments (GMM) using a complete
set of time dummies to capture the aggregate shocks and using lagged and twice-lagged capital
and twice-lagged profits as instruments. To implement this estimation, real profits and capital
stocks are calculated at the plant level. A more detailed discussion of the measurement of real
profits and capital as well as the estimation of the profit function and associated robustness issues
are provided in the Appendix. Our specification of the relatively simple AR(1) process for the
idiosyncratic shocks is motivated by the need to keep the state space relatively parsimonious for
the downstream numerical analysis and estimation.
The results give us an estimate of θ and an estimate of the process for the idiosyncratic
components of the profitability shocks. From the plant-level data, θ is estimated at 0·592 (0·006)
and ρε is estimated at 0·885 (0·004).14 The estimate of θ is significantly below 1, and this is
interesting in its own right. Using the LRD plant-level data on cost shares we estimate α L = 0·72,
which implies a demand elasticity of −6·2 and a mark-up of about 16%.15
Having estimated θ we recover ait from (8) and decompose it into aggregate and idiosyn-
cratic components using (9). This latter step amounts to measuring the aggregate shock as the
mean of ait in each year and the idiosyncratic shock as the deviation of ait from the year-specific
14. The S.E. are in the parentheses. The R 2 of the regression was 0·58.
15. While we do not estimate a production function in this paper, the existing plant-level literature suggests that
constant returns to scale (CRS) is a reasonable assumption (see, for example, Baily, Hulten and Campbell, 1992; Olley
and Pakes, 1996). If α L denotes labour’s coefficient in the Cobb–Douglas technology and ξ is the elasticity of the demand
curve, then θ = ((1 − α L )(1 + ξ ))/(1 − α L (1 + ξ )).

TABLE 4
Parameter estimates: λ = 1

Structural parameter estimates (S.E.) Moments
Spec. γ F ps Corr (i, i −1 ) Corr (i, a) Spike+ Spike− ˆ

£()
LRD 0·058 0·143 0·186 0·018
all 0·049 0·039 0·975 0·086 0·31 0·127 0·030 6399·9
(0·002) (0·001) (0·004)
γ only 0·455 0 1 0·605 0·540 0·23 0·028 53,182·6
(0·002)
ps only 0 0 0·795 0·113 0·338 0·132 0·033 7673·68
(0·002)
F only 0 0·0695 1 −0·004 0·213 0·105 0·0325 7390·84
(0·00046)
mean. Using this decomposition, we find that bt has an S.D. of 0·08, and with an AR(1) speci-
fication, the relevant AR(1) coefficient (denoted as ρb in what follows) is given by 0·76 with an
S.E. of 0·19. We also find that the S.D. of εit is 0·64.
To sum up, in what follows, we use the following key estimates from the data in our estima-
tion of adjustment costs: θ = 0·592, σε = 0·64, ρε = 0·885, σb = 0·08, ρb = 0·76. These were the
parameter values used in Section 3.5. These statistics imply that the innovations to the aggregate
shock process have an S.D. of 0·05 and the innovations to the idiosyncratic shock process have
an S.D. of 0·30. Neither process is estimated to have a unit root.
These moments of the shock processes are critical for understanding the nature of adjust-
ment costs since key moments, such as investment bursts, reflect the variability of profitability
shocks, the persistence of these shocks, and the adjustment costs associated with varying the
capital stock. Moreover, the characterization of these processes provide the necessary informa-
tion for the solution of the plant-level optimization problem, which requires the calculation of a
conditional expectation of future profitability.
4.1.2. Estimates of (F,γγ , ps ). Table 4 reports our results for different specifications
ˆ from (6), a measure of fit for the model. The first
along with S.E.16 The last column presents £()
row estimates the complete model with three structural parameters used to match four moments.
We are able to come fairly close to matching the moments with a vector of structural parameters
given by γ = 0·049, F = 0·039, ps = 0·9752, where λ ≡ 1 throughout.
These parameter estimates imply relatively modest, but statistically and economically sig-
nificant, convex, and non-convex adjustment costs. The estimates indicate that a model, which
mixes the various forms of adjustment costs, is able to best match the moments. This model can
produce the low serial correlation in investment as well as the muted response of investment to
shocks. Further, with the non-convex adjustment and the irreversibility, the model produces both
positive and negative investment bursts of the frequency found in the data.
Restricted versions of the estimated model are also reported for purposes of comparison.
Note how poorly the estimated quadratic adjustment cost does as it creates excessive serial corre-
lation as well as a large contemporaneous correlation between investment and the shocks. Inter-
estingly, the quadratic adjustment cost model can produce both positive and negative investment
16. In this table, corr(i, i −1 ) is the serial correlation of the plant-level investment rate and corr(i, a) is the correlation
of the investment rate and plant-level profitability.

spikes, reflecting the underlying shocks to profitability. In fact, the model with quadratic adjust-
ment costs has the largest fraction of positive investment spikes.
The various non-convex adjustment costs mute the response of investment to shocks. Fur-

ther, these other adjustment costs tend to produce negative serial correlation in investment rates
(such as the estimated model with F only). Both specifications with non-convex adjustment costs
are closer to the LRD moments than the quadratic model alone.
4.1.3. Evaluation. Are these results reasonable? Of interest relative to other studies are
our estimates of γ and ps . The quadratic adjustment cost parameter has received enormous atten-
tion in the literature since a regression of investment rates on the average value of the firm (termed
average Q) will identify this parameter when the profit function is proportional to K , and the cost
of adjustment function is convex and homogeneous of degree 1. Using the Q-theoretic approach,
estimates of γ range from over 20 (Hayashi, 1982) to as low as 3 (Gilchrist and Himmelberg,
1995, unconstrained subsamples, bond rating).
Our estimates of γ = 0·049 appear extremely low relative to other estimates.17 Direct com-
parison with other estimates should be viewed with caution given differences in methods and
data-sets. Moreover, our best-fitting model is the mixed model so it would be surprising if our
estimate of the convex costs are the same as that found by others as we are capturing in other
parameters what some studies are attempting to capture with only convex costs. Note, however,
that even if we use the estimate of γ from the γ-only model, our estimate of γ is low relative to
those in the literature.
In addition, much of the literature uses a Q-theory approach, and given the curvature in the
profit function in our analysis (recall we estimate θ = 0·59), the assumptions underlying Q-theory
do not hold. Put differently, the substitution of average for marginal Q produces a measurement
error. Following the arguments in Cooper and Ejarque (2001), this misspecification of Q-theory-
based models implies that any inferences about the size of the quadratic adjustment cost as well
as the significance about financial variables may be invalid.
To study this latter point, we simulated a panel data-set using our estimated model with
all forms of adjustment costs. From this data-set and the associated values from the dynamic
programming problem, we constructed measures of expected discounted average Q. We then
regressed investment rates on these measures of average Q and then inferred the value of γ
from the regression coefficient on average Q. When γ = 0·049, along with the other estimated
parameters, is used in the simulation, the coefficient on average Q in a regression of investment
rates on a constant and average Q is very precisely estimated at 0·2, implying an estimate of
γ = 5! Thus, the measurement error induced by replacing marginal with average Q creates
an inferred value of the quadratic adjustment cost parameter that is well within the range of
conventional estimates.18
Further, while others have considered models with non-convex costs of adjustment, there
are no estimates comparable to our estimate of the fixed cost.19 This estimate implies that the
17. One exception is the recent study by Hall (2002) in which he estimates quadratic adjustment costs for both
labour and capital. Hall finds an average (across industries) value of 0·91 for γ and essentially no adjustment costs for
labour.
18. Essentially, the substitution of average for marginal Q creates a negative correlation close to unity between
the “error” and average Q. Of course, this correlation goes to 0 if the profit function is proportional to K . Cooper and
Ejarque (2001) develop this point to argue that the same measurement error can explain the significance of profit rates in
Q regressions in the absence of capital market imperfections. That same result obtains here with non-convex adjustment
costs: profit rates are also significant when added as a regressor along with average Q.
19. In particular, neither CHP nor CEH estimate adjustment costs directly. Further, while fixed costs of adjustment
are present in the Abel and Eberly (1999) model they do not appear to be estimated either.

fixed cost of adjustment is almost 4% of average plant-level capital. This is a substantial fixed
cost.20
On ps , Ramey and Shapiro (2001) suggest that for some plants in the aerospace industry

that the value of ps is about 0·75 (this is based upon the resale prices of capital in this industry).
Our estimate is higher, but one problem with making such a direct comparison is that Ramey
and Shapiro focused on plants that were being shut down. Our empirical and theoretical analysis,
in contrast, focuses exclusively on continuing plants. The nature of irreversibility may be differ-
ent for a continuing business compared to a business that is shutting down. Understanding the
nature of how adjustment costs vary between continuing and entering and exiting plants is obvi-
ously an important topic for research in this area but is beyond the scope of this paper. Another
related problem for comparison is that Ramey and Shapiro consider plants that shut down due
to the shock associated with the end of the cold war and the fall of the Berlin Wall. For present
purposes, we do not believe the Ramey–Shapiro estimates are directly comparable to our estimate
of ps .
4.2. Estimation with opportunity costs: F = 0 and λ < 1

As other studies, such as Caballero and Engel (1999) and CHP, have introduced λ into the analy-
sis, we broadened our empirical model to incorporate this type of non-convex adjustment cost.21
With λ < 1, we capture any adjustment cost that disrupts the production process from, for exam-
ple, the shutting down of a production line or the reallocation of labour from production to the
installation of machines or training.
4.2.1. Estimates of θ and measuring profitability shocks. Introducing λ < 1 implies

that inferring profitability shocks and estimating θ separately from the estimation of the adjust-
ment costs is no longer possible. In particular, the presence of λ in the production function implies
that we must identify periods of low productivity from periods of capital adjustment.
One way to proceed would be to expand the set of moments to include the estimated serial
correlation and S.D. of the aggregate and idiosyncratic shocks in the set of moments. Then,
for each vector of parameters we could re-estimate the moments for the shocks following the
methodology outlined in Section 4.1.1. However, this would leave results that were not directly
comparable to those reported in Table 4.22
Instead, we adopted a two-step iterative procedure. We start with the curvature of the profit
function and the serial correlation and S.D. of the aggregate and idiosyncratic shock processes
as directly estimated in Section 4.1.1. We then proceed with the best fit of the estimation of the
adjustment cost parameters, including λ. We then use the simulated data on profits and capital to
estimate (10) and in so doing recover a new estimate of the curvature and the shock processes
based upon the simulated data. We compare the latter estimates from the simulated data with the
estimates of the curvature and shock processes from the actual data using (10). If they match, we
stop. If they don’t, we adjust the curvature and shock processes and repeat the process. While in
20. As noted by a referee, one possible concern with our specification is that the fixed cost is proportional to K , and
this will influence the investment decision. With this in mind, we estimated a version of the model in which the fixed cost
was proportional to the average capital stock of the plant. The resulting estimates were F = 0·05, λ = 1, γ = 0·069, ps =
0·90, and £() = 6801·8. As the value of £() is higher for this specification, we focus on the model given in (7).
21. In Caballero and Engel (1999), λ is treated as a random variable. This introduces an additional element of plant-
level heterogeneity that we do not consider. Instead, the plant-specific profitability shock interacts with a deterministic λ
to create plant-specific adjustment costs.
22. Further, it is computationally quite expensive to estimate all of these parameters.

TABLE 5
Parameter estimates: F = 0

Structural parameter estimates (S.E.) Moments
Specification γ λ ps Corr (i, i −1 ) Corr (i, a) Spike+ Spike− ˆ

£()
LRD 0·058 0·143 0·186 0·018
λ only 0 0·796 1·0 −0·009 0·06 0·107 0·042 9384·06
(0·0040)
All 0·153 0·796 0·981 0·148 0·156 0·132 0·023 2730·97
(0·0056) (0·0090) (0·0090)
principle this might take many iterations, in practice only very modest changes in the curvature
and shock processes are required to converge in one iteration.
4.2.2. Estimates of (λ λ,γγ , ps ). Table 5 summarizes our results. We find support for all
forms of adjustment costs. The row labelled “all” reports the results with all three types of ad-
justment costs.23 The estimated value of λ is significantly less than 1, indicating substantial
disruption costs of the capital adjustment process. We again find a modest degree of quadratic
adjustment costs and some evidence of irreversibility as well. This model fits the data much better
than the specification with F > 0, λ = 1. This is seen by comparing the values of £(). ˆ
The row in the table labelled “λ only” focuses solely on disruption costs. There is evidence
here of disruption costs but the model does not fit the moments as well as the “all” specification.
This result indicates that it is important to have all forms of adjustment costs in the specification.
Relative to previous results, Caballero and Engel (1999) estimate a model in which the
disruption costs are random. Further, they do not allow any other forms of adjustment costs.
Caballero and Engel (1999) report a mean adjustment cost of 16·5%, which, in our notation,
is a value of λ = 0·835. This latter value is quite close to ours, which is striking given that
they estimate their model with industry-level data, while we estimate ours using micro-data.
There are a number of subtle additional differences in methodology that may be at work as well.
Caballero and Engel assume that capital becomes immediately productive and also has stochastic
adjustment costs. Both of the latter imply lower average adjustment costs, which is consistent
with the pattern of the estimated λ values across the studies.
To obtain a better sense of the magnitude of adjustment costs in this model, we simulated
the estimated policy functions and calculated the resulting costs of adjusting the capital stock.
The average adjustment cost paid relative to the capital stock was 0·0091 and was 0·031 as a
fraction of profits.24
Though not reported in the table, we also estimated all four adjustment cost parameters,
= (F, γ , λ, ps ). We were unable to improve upon the fit summarized in Table 5: allowing
F > 0 did not enable us to better match the moments.
23. For these results we set the serial correlation of the idiosyncratic (aggregate) shock at 0·92 (0·82) and the
S.D. of the innovation to the shock was at 0·22 (0·05). At these parameter values, we are able to reproduce the serial
correlation and S.D. for the shocks reported using the methodology described above. In effect, this constitutes another
indirect inference procedure. Further, when we re-estimated the profitability function using the simulated data using the
same techniques as in Section 4.1.1 (but ignoring the effect of λ), we obtained a value of θ quite close to the value
assumed in the analysis.
24. We appreciate conversations with Anil Kashyap on these calculations. In the calculations reported here, when
we refer to the average adjustment costs as a fraction of profits, we are referring to the ratio of the expected value of
adjustment costs to the expected value of profits. An alternative would be to take the average of the ratio of adjustment
costs to profits. The latter is equal approximately to (1 − λ) times the fraction of periods with adjustment. Back-of-the-
envelope calculations suggest that these two alternatives yield roughly similar results.

TABLE 6
Sectoral parameter estimates

Parameter estimates (S.E.) Moments
Sector γ F λ ps corr(i, i −1 ) corr(i, a) spike+ spike− ˆ

£()
331-LRD 0·086 0·133 0·064 0·02 n/a
331-est. 0·0 0·07 1 0·946 −0·03 0·249 0·076 0·022 62·19
(0·0003) (0·0017) (0·0046)
0·015 0 0·70 0·76 0·041 0·146 0·073 0·018 8·13
(0·0037) (0·0344) (0·0167)
371-LRD 0·082 0·132 0·204 0·013 n/a
371-est. 0·012 0·069 1 0·962 0·069 0·338 0·112 0·037 452·96
(0·0026) (0·0057) (0·0106)
371-est. 0·051 0 0·679 0·8082 0·251 0·132 0·096 0·027 318·04
(0·0068) (0·0398) (0·0218)
LRD, Longitudinal Research Database; est., estimates.
4.3. Sectoral results

Our analysis of plant-level investment imposes the equality of various parameters (e.g. depreci-
ation rates, mark-ups, transition matrices for shocks, etc.) across sectors. Further, the overall fit
of the model, as measured by the £() ˆ statistic leaves some room for improvement. Thus, it is
interesting to study some specific sectors in detail. In this subsection, we re-estimate the model
for some leading sectors: steel (331) and transportation (371). For this exercise, we re-estimated
the curvature of the profit function and recalculated depreciation rates and transition matrices for
profitability shocks by sector.25
The estimation results for the structural parameters of the adjustment processes for the two
sectors are also reported in Table 6. Once again we find support for the presence of both convex
and non-convex adjustment costs along with irreversibility. Further, the specification in which
the non-convexity takes the form of disrupting the production process again fits the data best. We
again find small quadratic adjustment costs and evidence of irreversibility.
4.4. Robustness to alternative moments

In this subsection, we consider the robustness of our results to the choice of alternative moments.
As stated in Section 2.2, the moments we have chosen to match capture key features of investment
behaviour at the micro-level. We consider two alternative moments that capture the shape and
dispersion of investment illustrated in Figure 1.26 Specifically, rather than using the positive and
negative spike rates to capture the asymmetry and fat right tail of the investment distribution, we
use the 90th percentile and the 10th percentile of the investment rate distribution for each year
averaged over time.
The average 90th percentile from the LRD is 0·299 and the 10th percentile is given by
−0·014. These moments capture the asymmetry and fat right tail of the investment distribution.
When we use these two moments along with the two correlation moments in our analysis, the
estimated adjustment cost parameters are qualitatively and quantitatively similar to the parameter
25. The rates of physical depreciation were 0·076 for sector 331 and 0·063 for sector 371. The curvature of the
profit functions differs across these sectors and was 0·66 for 331 and 0·78 for 371, respectively. The AR(1) coefficients
for idiosyncratic and aggregate (sectoral) shocks, respectively, were 0·69 and 0·85 for 331 and 0·85 and 0·62 for 371.
The S.D. of the innovations for idiosyncratic and aggregate (sectoral) shocks, respectively, were 0·28 and 0·23 for 331
and 0·32 and 0·16 for 371.
26. These were suggested to us by the reviewers and the editor.

estimates reported in Table 5. That is, matching these alternative moments requires a relatively
modest convex cost component and substantial disruption adjustment costs and transaction ad-
justment costs. To be specific, the best fit for matching this alternative set of moments implies
an estimate of γ = 0·042, λ = 0·86, and ps = 0·80. These parameter estimates yield simulated

moments of corr(i, i −1 ) = 0·033, corr(i, a) = 0·133, the average 90th percentile investment rate
of 0·308, and the average 10th percentile investment rate equal to 0·00. As these alternative mo-
ments are estimated precisely in the actual data, the adjustment cost parameters are as tightly
estimated as those in Table 5.
5. AGGREGATE IMPLICATIONS
The estimation results reported in Table 5 indicate that a model, which mixes both convex and
non-convex adjustment processes can match moments calculated from plant-level data quite well.
An issue for macroeconomists, however, is whether the presence of non-convexity at the micro-
economic level “matters” for aggregate investment. In particular, there are economic forces, such
as smoothing by aggregation and relative price movements, which imply that non-convexities at
the micro-level may be less important for aggregate investment.
This issue of aggregate implications has already drawn considerable attention in the litera-
ture. CEH find that introducing the non-linearities created by non-convex adjustment processes
can improve the fit of aggregate investment models for sample periods with large shocks. CHP
similarly find that there are years where the interaction of an upward sloping hazard (investment
probability as a function of age) and the cross-sectional distribution of capital vintages matters in
accounting for aggregate investment.
We study the contribution of non-convex adjustment costs to aggregate investment (defined
by aggregating across the plants in our sample) in two ways. First, we compare aggregated and
plant-level moments. We use the term aggregated to indicate that the results pertain to aggregation
over our sample and thus may not accord with aggregate investment from, say, the National In-
come and Product Accounts (NIPA). Second, we compare the aggregate time series implications
of our estimated model, termed the best fit, against a model with quadratic adjustment costs.
For moments, we calculate the serial correlation of investment rates and the correlation of
investment rates and profitability from aggregated investment using the panel of manufacturing
plants. To be precise, we compute aggregate statistics from the LRD by creating a measure of the
aggregate investment rate and, using the series of profitability shocks described in Section 4.1.1,
a measure of aggregate profitability.
The results stand in stark contrast with the moments reported in Table 1. The serial correla-
tion of aggregate investment is 0·46, and the correlation between investment and the profitability
shock is 0·51 for the aggregated data. In contrast, the plant-level data exhibits much less serial
correlation, 0·058, and much less contemporaneous correlation between investment and shocks,
0·143.
How well does the best-fit model match these aggregate facts? If we compute aggregate
investment and the aggregate shock from a simulation using the best-fit model, the serial correla-
tion of aggregate investment is 0·63 and the correlation between investment and the profitability
shock is 0·54. Thus, aggregation of the heterogeneous plants alone substantially increases both
the serial correlation of investment and its correlation with profitability.
In fact, the aggregate moments reported above seem to be much closer to the prediction of
a quadratic cost of adjustment model: from Table 3, a model with quadratic adjustment costs
implies high serial correlation and high contemporaneous correlation of investment and shocks.
This suggests a second exercise in which we ask how well a quadratic adjustment cost model can
match the aggregate data created by the estimated model. To study this, we created a time series

simulation (periods) for the estimated model. We then searched over quadratic adjustment costs
models to find the value of γ to maximize the R 2 between the series created by the best-fit model
and that created by the quadratic model. A value of γ = 0·195 solved this maximization problem,

and the R 2 measure was 0·859. Thus, the quadratic model explains most but not all of the time
series variation from the best-fit model.
This analysis of the aggregate implications is potentially incomplete in that we ignore two
important factors. First, we do not explicitly consider general equilibrium effects.27 As empha-
sized by Caballero (1999), Thomas (2002), Veracierto (2002), and Kahn and Thomas (2003),
it is likely that there is further smoothing by aggregation due to the congestion effects that are
potentially present in the capital goods supply industry and/or due to endogenous interest rate
fluctuations.
Second, we work with a subset of manufacturing plants. In particular, we have selected a
balanced panel and have thus ignored entry and exit, including the investment associated with
that decision. Thus, our “aggregate results” refer to the aggregation over a fixed set of plants.
Nonetheless, the analysis uncovers strong effects of smoothing over heterogeneous plants
without variations in relative prices. While identifying the mechanisms that smooth out plant-
specific non-convexities is of interest, it should be clear that both smoothing by aggregation and
variations in factor prices are important to the smoothing process. That said, it is also clear that
the non-convexities at the plant level are not totally smoothed by aggregation: our goodness-of-fit
measure is 0·859 not 1!
6. CONCLUSIONS
The goal of this paper is to analyse capital dynamics through competing models of the invest-
ment process: what is the nature of the capital adjustment process? The methodology is to take
a model of the capital adjustment process with a rich specification of adjustment costs and solve
the dynamic optimization problem at the plant level. Using the resulting policy functions to cre-
ate a simulated data-set, the procedure of indirect inference is used to estimate the structural
parameters.
Our empirical results point to the mixing of models of the adjustment process. The LRD in-
dicates that plants exhibit periods of inactivity as well as large positive investment bursts but little
evidence of negative investment. The resulting distribution of investment rates at the micro-level
is highly skewed even though the distribution of shocks is not. A model, which incorporates both
convex and non-convex aspects of adjustment, including irreversibility, fits these observations
best. In particular, a model of adjustment in which the non-convex cost entails the disruption of
production fits the data best.
In terms of further consideration of these issues, we plan to continue this line of research by
introducing costs of employment adjustment. This is partially motivated by the ongoing literature
on adjustment costs for labour as well as the fact that the model without labour adjustment costs
implies labour movements that are not consistent with observation (see, e.g. Caballero, Engel and
Haltiwanger, 1997).
Further, it would be insightful to utilize this model to study the effects of investment tax
subsidies. Here, those subsidies enter quite easily through policy induced variations in the cost
of capital. Clearly, one of the gains to structural estimation is to use the estimated parameters
for policy analysis. An interesting aspect of that exercise will be a comparison of the estimated
27. Recall that we have been able to identify the adjustment costs using cross-sectional differences in investment
dynamics across plants having controlled for aggregate shocks. However, even though we have been able to identify
the adjustment costs, aggregate variation in investment will reflect the complex interaction of shocks, endogenous factor
prices, and adjustment dynamics.

model and a quadratic adjustment cost model in terms of their predictions of the aggregate effects
of an investment tax credit.
Finally, there are some methodological issues worth exploring further. For this exercise,

we have chosen to estimate the model using a simulated method of moments approach. There
are, of course, competing approaches, including maximum likelihood estimation (MLE) as well
as estimation from the Euler equations, including periods of inaction. In future research, we
plan on exploring these competing approaches. These alternative approaches have the potential
advantage in that they do not rely on matching specific moments but rather can confront the
micro-data directly.
Still, it is useful to emphasize that the simulated method of moments approach we use
here has a number of distinct advantages especially in this context. First, structural models of
investment with non-convex adjustment costs obviously imply a range of inaction. In the actual
micro-data, while we do observe some range of inaction as we report in Table 1, the more robust
finding is that the distribution of investment is skewed and kurtotic with a mass around 0 and a
fat right tail. Identifying inaction precisely at the micro-level is difficult because in practice there
is substantial heterogeneity in capital assets with associated heterogeneity in adjustment costs.
For example, buying a specific tool gets lumped into capital equipment expenditures in the same
way as retooling the entire production line. The former presumably has little or no adjustment
costs while the other is subject to presumably high adjustment costs. The implication is that
in pursuing MLE or Euler equation estimation using the actual micro-data a researcher must
define “inaction” without observing the underlying capital heterogeneity. Specifically, should a
researcher identify inaction as literally zero investment or small investment expenditures that
reflect “buying a wrench?”28 In contrast, we exploit robust moments of the investment and profit
distributions.
While we believe the moments we match are robust to capital heterogeneity, this discussion
reminds us of the limitations of even high-quality micro-data such as the LRD. The class of
adjustment cost models we focus on in this paper are best interpreted as applying to variations in
capital expenditures that are relatively homogeneous in type. It is unlikely that we will have a rich
longitudinal micro data-set on establishments with annual data on capital expenditures by detailed
asset class; unobserved heterogeneity in capital is a feature of reality that estimation of investment
dynamics with micro-data on plants needs to confront, regardless of the methodology used.
Another strength of our approach is that analysis and estimation does not require direct and
continuous access to the micro-data. Given that virtually all of the high-quality longitudinal mi-
cro data-sets are proprietary, it is very useful to have methods available that can take advantage of
moments from the micro-data that can be analysed off-site. The research community at large has
a much better chance of exploring alternative models of investment using the simulated method
of moments approach given limited direct access to the micro-data. Our findings suggest there
would be considerable value to statistical agencies producing summary measures of the distri-
butions of micro-investment behaviour and its auto covariance and cross-covariance with other
micro-measures.
In the end, there are many dimensions to improve the match between the models we specify
and estimate and the full richness of the actual micro-data. Despite these limitations, we have
identified features of the micro-data that can only be reconciled with models that contain both
convex and non-convex adjustment costs. In particular, a modest convex component and substan-
tial transaction and disruption costs are required to capture key features of micro-investment.
28. In related earlier work, CHP took a stand on this by defining investment spikes of investment greater than 20%
as the investment that is subject to fixed adjustment costs. They investigated the robustness of this admittedly ad hoc
threshold but noted that this was a limitation of their analysis. Note as well that Goolsbee and Gross (1997) consider a
model with heterogeneous capital goods.

APPENDIX
In this section, we discuss the measurement of key variables and the details and robustness of estimation for the
profit function. Real variable profits are measured as revenue less variable costs (labour and material) deflated by the

gross domestic product implicit price deflator for consumption. We make the assumption that measured real variable
profits provide an estimate of ( A, K ) = λAK θ in the model. The question then is how adjustment costs in the model
are captured in the measured real variable profits or other cost measures in the data. We think it is reasonable to assume
that some part of capital adjustment costs are reflected in real variable measured profits either due to the disruption of
productivity and/or perhaps equivalently that some of the labour that might have normally been used for production
is used for installing capital. It is precisely these arguments that motivate us to consider including an adjustment cost
factor via λ. We also think it is reasonable to assume that some adjustment costs take the form of purchased services or
contract work that are not captured in measured real variable profits. It is precisely these arguments that motivate us to
include adjustment costs that are additively separable from real variable profits and may be either convex or non-convex
in nature—hence we consider adjustment costs in the form of both γ or F. In terms of measurement in the LRD, there
are no annual data on such purchased services or contract work and so we cannot directly measure these costs. However,
we can infer the presence of these costs through the dynamics of investment.
As described in the text, we estimate the parameters of the real variable profit function using the quasi-differenced
(10). In practice, we use a transformed version of (10) taking advantage of assumptions that the production function
is Cobb–Douglas and that the demand function has constant elasticity. Specifically, we assume that the plant faces an
inverse demand function given by p = y −η and so has a revenue function of R(y) = y 1−η . Assuming that the production
function is given by y = AK α L φ and that K is predetermined, L is the variable factor(s), and ω is the price of the
variable factor(s). The equations that follow are based on one variable factor for expositional purposes but extend easily
to multiple variable factors and in our case there are two: labour and materials. Optimization over the variable factor
yields a revenue function R(K , A, ω), a profit function π(K , A, ω), and variable factor demand of L = h(K , A, ω). The
implied revenue and profit functions are given by
φ̃/(φ̃−1)
ω
R(K , A, ω) = A1/(1−φ̃) K α̃/(1−φ̃) (11)
φ̃
φ̃/(φ̃−1)
ω
π(K , A, ω) = (1 − φ̃) A1/(1−φ̃) K α̃/(1−φ̃) , (12)
φ̃
where α̃ = α(1 − η) and φ̃ = φ(1 − η). So the coefficient on K in both the revenue and profit functions is the same, given
by θ = α̃ . Moreover, the properties of the shocks to revenue and profits are the same up to a factor of proportionality.
1−φ̃
So the estimation strategy is to estimate θ from either a quasi-differenced profit or revenue regression on the capital
stock. The latter seems preferred since there is potentially less measurement error involved. There are a small number of
observations with negative measured real variable profits but by construction there are no businesses with negative real
revenue. While it may be that negative real variable profits are possible we suspect that this largely reflects measurement
error. To explore this issue we estimated the log-linear quasi-differenced real revenue function on all observations and
the log-linear quasi-differenced real profit function on only those observations with non-negative real variable profits. We
obtained very similar estimates of θ using both approaches. In the analysis in the paper we use the estimate of θ from the
real revenue quasi-differenced estimation, but this is not critical for the reported results.
To obtain the profit shocks, we use the estimate of θ and use (12) to infer the shock. We decompose the shock
into aggregate and idiosyncratic components (the aggregate shock is the first moment of the profit shock in any given
year, and the idiosyncratic shock is the residual after controlling for year effects). We then estimate the properties of the
aggregate and idiosyncratic shocks (both the degree of first-order autocorrelation and the variance of the innovations).
We note again that the properties of these shocks are quite similar across alternative ways of estimating θ.
To provide a sense of the robustness of both the estimates of θ as well as the properties of the shocks, we performed
a number of cross-checks. One cross-check that we perform is that the above procedures yield two alternative estimates of
ρε —one estimate is as described from inferring the shock from the profit function and the second is from the estimation
of the quasi-differenced revenue function. These two estimates of ρε are very similar to each other providing support for
this estimation strategy.
As a second cross-check, we explored the properties of the innovations to this first-order process. We found that the
innovations to the AR(1) representation of εit had a serial correlation very close to 0 (−0·05).
In addition, as a check on the robustness of our estimate of θ, we also estimated AR(2) specifications with appropriate
second quasi-differencing in our estimation of θ. We found θ was 0·60 when we assumed an AR(2) compared to the
estimate of 0·592 reported in the text with the AR(1) specification. There was essentially no improvement in the overall
fit of the model with an AR(2) specification. Interestingly, even for the ordinary least squares estimation we obtained an
estimate of θ of 0·591. Thus, the estimate of θ is very robust. As noted above, once we have an estimate of θ (which is

apparently very robust), the properties of the aggregate and idiosyncratic shocks are well captured by an AR(1) process
(e.g. the implied innovations are serially uncorrelated).
We note in closing that is it not uncommon in the firm-level literature to assume a first-order process for the un-
derlying shocks. For example, the Olley and Pakes (1996) and Levinsohn and Petrin (2000), hereafter LP, methods for

estimating production functions are based on the assumption of first-order Markov processes. A key difference between
the approach in their papers and that pursued here is that they use a more general first-order Markov process. For example,
LP specify the first-order process as the productivity shock in period t being a polynomial function of the productivity
shock in t − 1. As a further point of comparison, unlike these papers we are not seeking to identify the factor elasticities of
both variable and quasi-fixed factors of production. Rather, we seek to identify the coefficient on the quasi-fixed factor in
the profit function after having already maximized out the variable factors of production. As such, we are similar to LP’s
“second stage” where they identify the coefficient on capital. In LP’s second stage, they employ a GMM approach with
lagged values of inputs as instruments in a manner similar to that employed here (although again with the polynomial
specification for the first-order process their estimation is more complex).
Acknowledgements. The authors thank the National Science Foundation for financial support. Andrew Figura,
Chad Syversons, and Jon Willis provided excellent research assistance in this project. We are grateful to Shutao Cao for
his comments on the final version of this paper. Comments and suggestions from referees and the editor of this journal
are gratefully acknowledged. We are grateful to Andrew Abel, Victor Aguirregabiria, Ricardo Caballero, Fabio Canova,
V. V. Chari, Jan Eberly, Simon Gilchrist, George Hall, Adam Jaffe, Patrick Kehoe, John Leahy, David Runkle, and Jon
Willis for helpful discussions in the preparation of this paper. Helpful comments from seminar participants at Boston
University, Brandeis, CenTER, Columbia University, the 1998 Winter Econometric Society Meeting, the University of
Bergamo, and IFS Workshop on Applied Economics, the University of Texas at Austin, UQAM, Federal Reserve Bank
of Cleveland, Federal Reserve Bank of Minneapolis, Federal Reserve Bank of New York, Pennsylvania State University,
Wharton School, McMaster University, Pompeu Fabra, Yale, and the NBER Summer Institute are greatly appreciated.
The data used in this paper were collected under the provisions of Title 13 U.S. Code and are available for use at the
Center for Economic Studies (CES) at the U.S. Bureau of the Census. The research in this paper was conducted by the
authors as Research Associates of CES. The views expressed here do not represent those of the U.S. Census Bureau.
REFERENCES
ABEL, A. and EBERLY, J. (1994), “A Unified Model of Investment under Uncertainty”, American Economic Review,
84, 1369–1384.
ABEL, A. and EBERLY, J. (1996), “Optimal Investment with Costly Reversibility”, Review of Economic Studies, 63,
581–593.
ABEL, A. and EBERLY, J. (1999), “Investment and q with Fixed Costs: An Empirical Analysis” (Mimeo, University of
Pennsylvania).
BAILY, M., HULTEN, C. and CAMPBELL, D. (1992), “Productivity Dynamics in Manufacturing Establishments”,
Brookings Papers on Economic Activity: Microeconomics, 187–249.
CABALLERO, R. (1999), “Aggregate Investment”, in J. Taylor and M. Woodford (eds.) Handbook of Macroeconomics
(Amsterdam: North-Holland) 813–862.
CABALLERO, R. and ENGEL, E. (1999), “Explaining Investment Dynamics in U.S. Manufacturing: A Generalized
(S,s) Approach”, Econometrica, 67, 783–826.
CABALLERO, R. and ENGEL, E. (2003), “Adjustment is Slower Than You Think” (NBER Working Paper No. 9898,
National Bureau of Economic Research).
CABALLERO, R., ENGEL, E. and HALTIWANGER, J. (1995), “Plant-Level Adjustment and Aggregate Investment
Dynamics”, Brookings Papers on Economic Activity, 2, 1–39.
CABALLERO, R., ENGEL, E. and HALTIWANGER, J. (1997), “Aggregate Employment Dynamics: Building from
Microeconomic Evidence”, American Economic Review, 87, 115–137.
COOPER, R. and EJARQUE, J. (2001), “Exhuming Q: Market Power vs. Capital Market Imperfections” (NBER Working
Paper No. 8182, National Bureau of Economic Research).
COOPER, R. and HALTIWANGER, J. (1993), “The Aggregate Implications of Machine Replacement: Theory and
Evidence”, American Economic Review, 83, 360–382.
COOPER, R., HALTIWANGER, J. and POWER, L. (1999), “Machine Replacement and the Business Cycle: Lumps and
Bumps”, American Economic Review, 89, 921–946.
DOMS, M. and DUNNE, T. (1994), “Capital Adjustment Patterns in Manufacturing Plants” (Mimeo, Center for Eco-
nomic Studies, U.S. Bureau of the Census).
GILCHRIST, S. and HIMMELBERG, C. (1995), “The Role of Cash Flow in Reduced-Form Investment Equations”,
Journal of Monetary Economics, 36, 541–572.
GOOLSBEE, A. and GROSS, D. (1997), “Estimating Adjustment Costs with Data on Heterogeneous Capital Goods”
(NBER Working Paper No. 6342, National Bureau of Economic Research).
HALL, R. (2002), “Industry Dynamics with Adjustment Costs” (NBER Working Paper No. 8849, National Bureau of
Economic Research).
HAMERMESH, D. and PFANN, G. (1996), “Adjustment Costs in Factor Demand”, Journal of Economic Literature, 34,
1264–1292.

HAYASHI, F. (1982), “Tobin’s Marginal and Average q: A Neoclassical Interpretation”, Econometrica, 50, 213–224.
HOLT, C., MODIGLIANI, F., MUTH, J. and SIMON, H. (1960) Planning Production, Inventories, and Work Force
(Englewood Cliffs, NJ: Prentice-Hall).
HUGGETT, M. and OSPINA, S. (2001), “Does Productivity Fall After the Adoption of New Technology?”, Journal of

Monetary Economics, 48, 173–195.
ITO, H., BRESNAHAN, T. and GREENSTEIN, S. (1999), “The Sources and Effects of Investment Irreversibility: Large
Scale Computing” (Mimeo, Stanford University).
KHAN, A. and THOMAS, J. (2003), “Nonconvex Factor Adjustments in Equilibrium Business Cycle Models: Do Non-
linearities Matter?”, Journal of Monetary Economics, 50, 331–360.
LEVINSOHN, J. and PETRIN, A. (2000), “Estimating Production Functions Using Inputs to Control for Unobservables”
(NBER Working Paper No. 7819, National Bureau of Economic Research).
NILSEN, O. and SCHIANTARELLI, F. (1998), “Zeroes and Lumps in Investment: Empirical Evidence on Irreversibili-
ties and Nonconvexities” (Mimeo, Boston College).
OLLEY, G. S. and PAKES, A. (1996), “The Dynamics of Productivity in the Telecommunications Equipment Industry”,
Econometrica, 64, 1263–1297.
PECK, S. (1974), “Alternative Investment Models for Firms in the Electric Utilities Industry”, Bell Journal of Economics
and Management Science, 5, 420–457.
POWER, L. (1998), “The Missing Link: Technology, Investment and Productivity”, Review of Economics and Statistics,
80, 300–313.
RAMEY, V. and SHAPIRO, M. (2001), “Displaced Capital”, Journal of Political Economy, 109, 958–992.
ROTHSCHILD, M. (1971), “On the Cost of Adjustment”, Quarterly Journal of Economics, 85, 605–622.
SAKELLARIS, P. (2001), “Patterns of Plant Adjustment” (Working Paper No. 2001-05, Finance and Economics Dis-
cussion Series, Division of Research and Statistics and Monetary Affairs, Federal Reserve Board, Washington,
DC).
SMITH, A. (1993), “Estimating Nonlinear Time-Series Models Using Simulated Vector Autoregressions”, Journal of
Applied Econometrics, 8, S63–S84.
TAUCHEN, G. (1986), “Finite State Markov-Chain Approximation to Univariate and Vector Autoregressions”, Eco-
nomics Letters, 20, 177–181.
THOMAS, J. (2002), “Is Lumpy Investment Relevant for the Business Cycle?”, Journal of Political Economy, 110,
508–534.
VERACIERTO, M. (2002), “Plant Level Irreversible Investment and Equilibrium Business Cycles”, American Economic
Review, 92, 181–197.

Cooper and Haltiwanger (2005)

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Cooper and Haltiwanger (2005)

Uploaded by

Copyright:

Available Formats

Review of Economic Studies (2006) 73, 611–633 0034-6527/06/00230611$02.

Downloaded from https://academic.oup.com/restud/article-abstract/73/3/611/1576826 by London School of Economics user on 22 July 2020

Downloaded from https://academic.oup.com/restud/article-abstract/73/3/611/1576826 by London School of Economics user on 22 July 2020

c 2006 The Review of Economic Studies Limited

Downloaded from https://academic.oup.com/restud/article-abstract/73/3/611/1576826 by London School of Economics user on 22 July 2020

It = EXPt − RETt (1)

c 2006 The Review of Economic Studies Limited

Downloaded from https://academic.oup.com/restud/article-abstract/73/3/611/1576826 by London School of Economics user on 22 July 2020

c 2006 The Review of Economic Studies Limited

Downloaded from https://academic.oup.com/restud/article-abstract/73/3/611/1576826 by London School of Economics user on 22 July 2020

LRD, Longitudinal Research Database.

c 2006 The Review of Economic Studies Limited

We estimate adjustment cost parameters by using a simulated method of moments approach.

Downloaded from https://academic.oup.com/restud/article-abstract/73/3/611/1576826 by London School of Economics user on 22 July 2020

3. MODELS AND QUANTITATIVE IMPLICATIONS

V (A, K ) = max ( A, K ) − C(I, A, K ) − p(I )I + β E A |A V (A , K ) ∀(A, K ), (3)

c 2006 The Review of Economic Studies Limited

Downloaded from https://academic.oup.com/restud/article-abstract/73/3/611/1576826 by London School of Economics user on 22 July 2020

Moment LRD No AC CON NC-F NC-λ TRAN

LRD, Longitudinal Research Database.

3.1. Common elements of the specification

c 2006 The Review of Economic Studies Limited

3.2. Convex costs of adjustment

Downloaded from https://academic.oup.com/restud/article-abstract/73/3/611/1576826 by London School of Economics user on 22 July 2020

i = (1/γ )[β E Vk (A , K ) − p], (5)

3.3. Non-convex costs of adjustment

V (A, K ) = max{V i (A, K ), V a (A, K )} ∀(A, K ),

Downloaded from https://academic.oup.com/restud/article-abstract/73/3/611/1576826 by London School of Economics user on 22 July 2020

3.4. Transactions costs

V (A, K ) = max{V b (A, K ), V s (A, K ), V i (A, K )} ∀(A, K ),

V b (A, K ) = max ( A, K ) − pb I + β E A |A V (A , K (1 − δ) + I ),

V s (A, K ) = max ( A, K ) + ps R + β E A |A V (A , K (1 − δ) − R),

c 2006 The Review of Economic Studies Limited

Downloaded from https://academic.oup.com/restud/article-abstract/73/3/611/1576826 by London School of Economics user on 22 July 2020

3.5. Evaluation of illustrative models

c 2006 The Review of Economic Studies Limited

Downloaded from https://academic.oup.com/restud/article-abstract/73/3/611/1576826 by London School of Economics user on 22 July 2020

£() = min[ d −  s ()] W [ d −  s ()], (6)

4.1. Estimation with fixed costs: F > 0 and λ = 1

V (A, K ) = max{V b (A, K ), V s (A, K ), V i (A, K )} ∀(A, K ), (7)

c 2006 The Review of Economic Studies Limited

Downloaded from https://academic.oup.com/restud/article-abstract/73/3/611/1576826 by London School of Economics user on 22 July 2020

4.1.1. Estimates of θ and measuring profitability shocks. Using the assumption of λ =

( Ait , K it ) = Ait K itθ , (8)

πit = ρε πit−1 + θkit − ρε θ kit−1 + bt − ρε bt−1 + ηit . (10)

c 2006 The Review of Economic Studies Limited

Downloaded from https://academic.oup.com/restud/article-abstract/73/3/611/1576826 by London School of Economics user on 22 July 2020

Spec. γ F ps Corr (i, i −1 ) Corr (i, a) Spike+ Spike− ˆ

LRD, Longitudinal Research Database.

c 2006 The Review of Economic Studies Limited

Downloaded from https://academic.oup.com/restud/article-abstract/73/3/611/1576826 by London School of Economics user on 22 July 2020

c 2006 The Review of Economic Studies Limited

Downloaded from https://academic.oup.com/restud/article-abstract/73/3/611/1576826 by London School of Economics user on 22 July 2020

4.2. Estimation with opportunity costs: F = 0 and λ < 1

4.2.1. Estimates of θ and measuring profitability shocks. Introducing λ < 1 implies

c 2006 The Review of Economic Studies Limited

Downloaded from https://academic.oup.com/restud/article-abstract/73/3/611/1576826 by London School of Economics user on 22 July 2020

Specification γ λ ps Corr (i, i −1 ) Corr (i, a) Spike+ Spike− ˆ

LRD, Longitudinal Research Database.

c 2006 The Review of Economic Studies Limited

Downloaded from https://academic.oup.com/restud/article-abstract/73/3/611/1576826 by London School of Economics user on 22 July 2020

Sector γ F λ ps corr(i, i −1 ) corr(i, a) spike+ spike− ˆ

LRD, Longitudinal Research Database; est., estimates.

4.3. Sectoral results

£() = min[ d − s ()] W [ d − s ()], (6)